By Emil Widdig (WHU - Otto Beisheim School of Management)
Passive investing is one of the most hotly debated topics in modern times. And for a very good reason, since it has fascinating implications for financial markets. In recent years, money managers such as Howard Marks, Peter Lynch, and Michael Burry have fuelled discussions about the impact of passive investing on markets. As a consequence, one question arises: what is the impact of passive capital on financial markets?
Section 1: The Incredible Rise of Passive Capital
Since the inception of the first index fund, passive capital has seen a remarkable rise to popularity. Passive capital now makes up about 45% of U.S. equities.
As one of the most disruptive innovations in finance, ETFs have played a crucial role in the rise of passive capital.
Section 2: The Impact of Passive Capital
Passive funds are also active participants in equity markets. Portfolio rebalancing and cash inflows mean that index funds must engage in transactions that influence the market.
Index funds could lead to a divergence from intrinsic values, as they are investing in equities based on index demand, not based on attractiveness.
Constant capital inflows into passive investments could have inflated prices of index assets leading to increased performance of the indices
Most importantly, index funds could have contributed to an increase in correlation of equities included in indices.
Section 3: Implications for Investors and Money Managers
Active management has seen large amounts of capital outflows along with increased pressure on profitability.
Passive management is involved in price wars leading to a search for revenues. Firms such as BlackRock are now among the most powerful firms of Wall Street, managing over $7 trillion in assets under management.
The Incredible Rise of Passive Capital
Even though the debate about the impact of passive investing is fairly recent, its history started as far back as 1951, when John Bogle wrote his thesis “The Economic Role of the Investment Company”, in which he stated that active managers couldn’t beat the market, hinting at an index fund. Two years later, a young graduate student named Harry Markowitz, who would later receive a Nobel prize for his works, started what would become the field of Modern Portfolio Theory. The theory put returns in relation to risk for the first time and argues that the only sensible thing an investor can do is invest in the market portfolio. With academics fully convinced that markets were efficient with no way for investors to beat the average return, it was again John Bogle who founded the first index fund in 1975. Bogle’s fund would later be renamed the Vanguard 500 Index Fund, eventually becoming one of the leading players in the field.
The rise of passive investing came at a time in which mutual funds, often underperforming the wider market and charging absurdly high fees at the same time, were ruling the investment markets. In times like these, it was no wonder that index-tracking products gained a large following quickly. In 1990, a small team from Canada created the first fund that could be traded freely at the Toronto stock exchange that charged no management fees. The first Exchange Traded Fund was born. It did not take long until the first versions emerged in the US and all over the world; with it, the investment world would be changed forever.
Figure 1: Assets Under Management of Index Funds and ETFs
Source: Financial Times (Financial Times)
As one of the most important financial innovations in the last decades, Exchange Traded Funds (ETFs) have propelled passive investing to massive popularity. Today, ETFs alone account for about a quarter of daily trading volumes and make up about $5 trillion of total equities having surpassed assets under management of active managers in late 2019. Assets under management could exceed $10 trillion by 2022 and might even skyrocket to $50 trillion in 2030, according to Bank of America. ETFs, while being the most popular and famous product for passive investing, isn’t the only medium through which passive capital is deployed. Including mutual funds, passive capital as a whole makes up about 45% of all U.S. equities. With so much capital being managed passively, this begs the question: What impact does the massive increase in passive capital have on financial markets and the economy as a whole?
The Impact of Passive Capital
Let’s start by discussing why passive investing remains one of the most attractive investments for individual and institutional investors alike. According to the Financial Times, over a period of ten years, 83% of actively managed funds underperformed their benchmark, which, most of the time, is an index. This most likely results from the increased competition in financial markets due to easier access to financial research and increased attention of the wider public. The rationale for investing in an index seems to be that if money managers can’t beat the market and mostly generate below-average returns, why not invest in a cheap passively managed fund and at least save the performance fees. In addition, most, if not all the funds that are outperforming the market and deliver attractive returns are very hard to access, requiring vast amounts of capital or even not being accessible to the public at all. Famously, Medallion, the flagship fund of quantitative hedge fund Renaissance Technologies only manages employees’ money and does so very successfully, generating average returns of 39% per year after fees over the last 30 years.
One of the most significant benefits of passive investing, above all, is diversification. After all, that is what has propelled passive investing to such popularity - no risk of underperformance and no significant risk exposure to individual stocks. While diversification could also be reached otherwise and most actively managed funds are also diversified in one way or the other, in the case of passively managed funds, management fees are vastly lower. Hedge funds have established a 20% performance fee on returns and a 2% management fee on assets under management while passively managed funds charge as little as 0.02% on assets under management with no performance fees.
Now that we have got that settled, let's talk about the impact passive investing is having on the markets. The most important concept to understand is that index funds are not passive market participants. Index funds need to buy and sell the underlying equities according to the demand of the fund. This concept is best explained by looking at one of the popular arguments against active management. One of the key arguments against active capital management goes like this: Active managers are essentially involved in a zero-sum game. In sum, all active managers together are holding the market portfolio. So let’s say you would invest in every active fund out there. The argument says that you would essentially hold the market portfolio, and all of the funds managers would fight against each other for outperformance of the broader market. You would receive the returns of the market portfolio but less the fees that the fund managers charge. On paper, this argument makes sense. In practice, however, it leaves out one key component. Index funds are not actually passive. They must rebalance their portfolio, buy additional assets or reduce their portfolio size. In practice, there is interaction between actively and passively managed funds. Even though we call them passive investments, they are still engaging in markets because they are continually executing transactions. In fact, as described earlier, passively managed funds are some of the largest players in today's market, so they are most definitely going to impact markets.
The first impact passive investing could have on financial markets is a divergence from intrinsic values. Transactions of index funds are not based on any fundamental analysis of the underlying assets but instead only based on current demand levels of the index. Capital will not flow to the most attractive investment; it will flow to the most popular one. Index funds aren’t the only funds that do not look at equity fundamentals. In recent years another investment product has found its way to mainstream success. So-called smart-beta funds utilize investment rules other than the traditional portfolio allocation method according to market capitalizations used by index funds. Smart-beta funds might construct its portfolio based on factors like past dividend payments, or balance sheet ratios. Through these investment rules, smart-beta funds aim to simulate actively managed strategies. Even though they are trying to simulate active investment, and although they aren’t passive investment funds, they have more in common with passive funds than active ones. The biggest similarity: They are also not looking at business fundamentals before investing. And although having nothing in common with passive investments, quantitatively managed funds also contribute to a growing number of market participants ignorant to business fundamentals. All of these non-active investment strategies hold up to 80% of the stock market. Only 20% of the stock market even considers analysing the business it invests in before buying into it. This not only means that prices could diverge from intrinsic values, but also that management of companies is less incentivized to adhere to proper capital allocation. Financial markets have historically rewarded companies with good capital allocation through cheaper access to capital and in turn, directed the money where it is of the best use to society. Without such rewards for capital allocation, we could be seeing harm to the broader economy.
Much of the appeal of passive investing also stems from its performance over recent years. Michael Green, Chief Strategist at hedge fund Logica Capital attributes this phenomenal performance to the incredible capital inflows index funds have experienced over past years. The attractive performance of index funds attracts capital which leads to capital inflows. These capital inflows lead to increased demand for the underlying assets in the index, which leads to higher prices and in turn higher returns. These returns spark additional investments into the index repeating the cycle. Here is Bill Ackman of Pershing Square explaining the phenomenon: “Large and growing inflows to index funds, coupled with their market-cap-driven allocation policies, drive index component valuations upwards.” Index funds are “inherently momentum investors, forced to buy more as stock prices rise, magnifying the risk of overvaluation of the index components”. Vincent Deluard of Stone X Group was able to show the effect of capital inflows on equity markets. He identified stocks in the Russell 3000 index that were over proportionally represented in index funds and compared them to other stocks that were under proportionally represented. He found that stocks that were represented by more than 200 indices were 2.5 times as expensive as stocks that are represented in under 75 indices. While only being a correlation, it does hint at passive investing influencing market equity prices. Nowadays, inflows into index funds also come from regulatory changes. Passive investing is now a standard in retirement and savings plans, and access to passive investments is easier than it has ever been. Among millennials, as much as 95% of investments are passive hinting to the possible popularity of passive investments in the future.
The effect index funds have on equity prices can also be seen in stocks that are newly included in indices. When a stock is included in an index, funds must buy the stock in order to reflect the index. According to Jeffrey Wurgler, Professor of Finance at New York University, this leads to price increases of 9% throughout the time of index inclusion.
The most critical impact of passive investing is that the prevalence of passive funds could lead to equities becoming more correlated to each other. A stock included in an index begins to correlate significantly with the index it is included in. This has severe implications for investors seeking a diversified portfolio. Once the goal of passive investing, index funds could now face the problem of not being diversified after all. Investors are no longer investing in individual stocks but instead in groups of stocks increasing the correlation of these groups of stocks. Diversification can only be successful if equities move independently from each other. Index funds not being as diversified as they might seem could already make passive investment much less attractive, and even more important it also might have serious implications for global financial stability. The increased correlation of index equities could make selloffs and financial crises even more severe.
Figure 2: Changes in co-movement of stocks included in the S&P 500 Index Source: Jeffrey Wurgler (Jeffrey Wurgler)
Implications for Investors and Money Managers
The rise of passive investing also has many implications for investors and the money management industry.
First off, active management has seen drastic amounts of capital outflows over recent years. As already discussed, one of the reasons for this outflow is the underperformance of active managers compared to their index benchmark. The industry might be in a vicious cycle in which these outflows that are invested in passive capital instead might be increasing asset prices and in turn the return of indices. Because these indices also are the benchmarks of active managers, this will lead to the perception that active managers are underperforming the market. This might again lead to additional capital outflows repeating the cycle. Passive funds have put active managers under a lot of pressure. The capital outflows experienced by active managers combined with higher and higher costs to generate acceptable returns are hurting their profits. In the future, active managers will have to think about how to remain attractivse in a world of easily accessible exchange traded funds and low fees.
Figure 3: Cumulative capital flows of active and passive investments Source: Howard Lindzon (Howard Lindzon)
On the other side of the spectrum, index funds are also fighting with slim profit margins. With index funds nearly indistinguishable from each other - after all, they are only tracking a predetermined index - price becomes the deciding factor for investors. As index funds are outbidding themselves in hopes of generating higher revenues to cover their costs, the race to zero fees is in full turmoil. Index funds are constantly looking for ways to reduce costs, such as automation, or increase revenues, such as securities lending and pursuing additional revenue streams such as the business of advice. We could also see a wave of consolidation hitting the index fund industry as there will likely not be enough space for 18 ETFs tracking the same index, as in the case of the S&P 500.
The rise of passive investing has brought a new ruling class to Wall Street. Powerhouses such as Blackrock and Vanguard, with $7.4 and $6.2 trillion assets under management respectively have gained large amounts of power. Larry Fink, chairman and CEO of BlackRock could potentially be the most powerful man in modern finance. His close connections to politics enabled him to get access to opportunities such as after the financial crisis when BlackRock was contracted to help the U.S. government. In the process, BlackRock swept up assets left over from the ruins of the financial crisis and took over the management of the $5 trillion balance sheet of Fannie Mae and Freddie Mac.
In the end, much of the consequences of passive capital remain to be seen. The debate about the impact of passive capital is still evolving. One thing is for sure; passive capital will have an enormous impact on financial markets. The only question that remains to be seen is, what that impact will eventually look like. Index funds have been on an exciting-to-watch journey disrupting the whole money management industry. It will surely be even more fascinating to see future developments surrounding passive capital and the ways in which it will shape financial markets.